[GreenYes] Review of Subsidies in the Energy Tax Incentives Act of 2002

["Doug Koplow" <koplow@indecon.com>]

Dear List Serve Members,

Given the past work I've done on subsidies to energy and recycling, and the inquiries I've received on the implications of current legislative efforts, I decided to review the subsidies included in the "Energy Tax Incentives Act of 2002."  This bill is scheduled for mark-up in the Senate Finance Committee today.  As I know others on these list serves are interested in this topic as well, I am distributing my review here.  Apologies for any cross-postings.

Please recognize that the information here reflects my opinions alone, and the discussion below does not address every provision in the bill.  A Word version of this review is available upon e-mail request.  

Hope you find it useful.

-Doug Koplow, Earth Track, Cambridge, MA

I)  Extension of Section 45 Electricity Production Credits to open-loop biomass and swine and bovine waste nutrients.

The eligibility of a wide range of biomass sources for section 45 tax credits, irrespective of whether they were sustainably produced or not, will exacerbate problems associated with poor land management.  The policy will encourage timber producers and farmers to strip residual biomass from their lands for conversion to energy, eliminating an important source of habitat following clear-cuts (in timber) and of nutrient renewal on farms.  The policy will add to a huge baseline of existing farm subsidies in encouraging large scale, monoculture production rather than sustainable agriculture.  It will also slow expansion of recycling and composting programs, and may contribute to less sustainable timber management practices.  Since economies of scale are important in the collection, processing, and conversion of residual biomass, it is likely that this policy will benefit primarily large producers and landowners.

The JCT has estimated revenue losses of $3.2 billion over ten years.  I believe this value to be too low.  The existing language in the proposal suggests the cost will be much higher:

-Because credits can be earned through co-firing in coal boilers, new plants do not need to be built in order to start getting tax credits.  JCT estimates peak losses to the Treasury won't occur until year 4; with co-firing, this could happen much sooner.  Even assuming JCT's peak values are accurate, quicker peak values would add roughly $300-$400 million to losses over the 10-year period analyzed (2002-2012).

-Open-loop biomass facilities would be eligible to receive credits even if they are already operating.  In addition to making no economic sense (tax subsidies are normally implemented to change behavior, not subsidize the continuation of existing behavior), this allowance also suggests that large revenue losses will begin immediately upon enactment.

-Even tax-exempt public utilities benefit from the changes, since they can sell their tax credits (which normally cannot be transferred among taxpayers) to investors.  The investors tend to come from the highest marginal tax brackets, further increasing revenue losses.

-One example may be illustrative:  the paper industry is one of the largest sources of self-generated energy from biomass in the country.  In 1998, the industry self-generated 49.3 million kWh from cogeneration sources (primarily biomass).  Although the Act provides a reduced tax credit for existing facilities (1.0 cents versus 1.5, which translates to 1.13 cents after scaling for the inflation allowance), this still generates roughly $558 million per year in benefits if all existing generation got the credit.  Currently operating facilities could earn the credit through December 31, 2005, a period of almost 4 years from now, generating revenue losses of more than $2 billion from the paper industry alone, and providing no net increase in the biomass used.  If this example is indicative, JCT's estimated revenue loss of $320 million per year from all biomass sources may be much too low.
 
Some of the other specific eligibility criteria of concern include:

-Subsidizing factory farms.  Tax credits for swine and bovine manure and litter will primarily flow to large operators of concentrated animal feedlot operations, again because of economies of scale associated with waste collection and conversion.  Along with weak water and air pollution controls for these operators, the tax credit will further weaken the market position of small, independent meat producers.

-Pallet burning over recycling.  Tax credits for burning waste pallets will destroy the incentive to recycle these objects, currently one of the largest uses of hardwoods in the United States.

-New impediment to construction waste recycling.  Tax credits for construction wastes will harm fledgling efforts at recycling of construction debris.

-Unclear impact on future ability to grow paper recycling.  While the tax credits exclude "paper that is commonly recycled," it is likely that the economic reward for burning less recoverable grades will slow the expansion of recycling into new paper grades.

-Properly excludes new subsidies to landfills and waste incineration.  To its credit, the Act does exclude subsidies to landfill gas and solid waste-to-energy plants, which had been included in other iterations.  Both subsidies would have further eroded the market position of recycling relative to waste disposal.

RECOMMENDATIONS RELATED TO THIS PROVISION:

1)  There should be no subsidization of existing facilities.
2)  Subsidies to open-loop biomass should be eligible only to small facilities, not be large agribusiness, paper, or timber interests.  This will ensure that the policies to not exacerbate the competitive disadvantages faced by small businesses in these sectors.
3)  Subsidy eligibility should be linked to the sustainability of timbering and cropping practices in use by the firms claiming the credits.
4)  Credits should not be allowed to offset debt obligations associated with Rural Electrification Loans.
5)  The Committee should more precisely define what grades of paper are "not commonly recycled" to present a clear picture of how the Act would affect paper recycling.
6)  Waste pallets should not be eligible for the tax credit.

II)  Small Producer Ethanol Credit

As written, the Act would quadruple the size of ethanol producers eligible for the small producer ethanol credit, up to 60 million gallons of capacity per year.  This increases the number of eligible producers from roughly 22 under current law to 52, or nearly 90% of all ethanol producers in the country.  The Act also makes the credits much more valuable to taxpayers by eliminating constraints on its use.  The estimated cost is by JCT is $171 million over ten years.

RECOMMENDATION:

The production of ethanol in the United States continues to rely heavily on corn as a feedstock.  Despite claims by the USDA and the industry, there is still some controversy over whether with ethanol from corn even generates a net gain in energy, given the petroleum intensity of domestic corn production.  Until ethanol can be made from more sustainable feedstocks, expanding the already large subsidies to ethanol makes no sense and should be eliminated from the bill.

III)  Clean Coal Incentives

There is no argument that Clean Coal is better than dirty coal.  However, it is also true that clean coal is still much dirtier than a host of other energy sources.  The proposal under consideration would provide three new credits for clean coal facilities.  In addition, tax-exempt coal-burning utilities would be able to generate and sell tax credits for their clean coal activities, further increasing the revenue losses from the proposal.

The JCT estimates revenue losses of nearly $2 billion over a ten-year period for clean coal support.  This is on top of existing direct subsidies to technology development through the Department of Energy.  

RECOMMENDATION:  There should be no tax breaks to clean coal programs; public funds would be better spent on cleaner energy sources elsewhere.    

IV)  Oil and Gas Provisions

The tax system for large corporations in the United States is based primarily upon the accrual method:  if you have costs (revenues) that span more than one year, you match recognition of them to the period over which they are incurred (earned).  This helps make the tax system more neutral with respect to capital-intensive versus service-intensive methods of meeting a market need.  It also helps make the underlying economics of the business in question more transparent.  

Oil and gas industries have long gotten large exemptions from these general rules. While of course every industry would like to be able to deduct every expenditure from taxes immediately, this is not in the best interest of either general society or the taxpayer.  Yet, the Energy Tax Incentives Act of 2002 widens these subsidies still further.  

Natural gas gathering pipelines can be written off more quickly than their service life (revenue loss of $87 million over 10 years), as can natural gas distribution lines ($1.4 billion over 10 years); compliance costs with environmental regulations for sulfur control can be written off immediately for small refiners ($57 million over 10 years); all survey costs can be written off in 2 years, rather than over the life of the properties surveyed ($675 million over 10 years); and rental payments, which hold the rights to drill in particular areas, can be written off in 2-years, rather than over the life of the lease ($672 million over 10 years).  

Thankfully, and unlike the biomass tax credits, only new expenses and investments would be eligible for these breaks.  However, all of the policies will nonetheless work against efforts to curb reliance on fossil fuels that are pending, in one form or another, to address concerns over global warming.

RECOMMENDATION:

Rather than introduce a host of new subsidies to rejuvenate domestic oil and gas production, Congress should instead remove subsidies that benefit foreign oil production (thereby placing domestic producers at a competitive disadvantage).  This alternative strategy would achieve the dual objectives of making markets more transparent and efficient, while simultaneously achieving the policy objective of helping the domestic oil and gas sector.

Ensuring that corporations are no longer able to disguise oil and gas royalty payments to foreign governments as foreign tax payments (the latter may be used to offset domestic taxes due) could reduce the incremental subsidy to foreign producers by between $500 million and $1 billion per year.  (This is a separate phenomenon from legitimate foreign taxes paid, which should remain deductible from US taxes due.)  In addition, recovering even a small portion of the cost to defend oil shipping lanes in the Persian Gulf directly from oil consumers would also help remove artificial market advantages that foreign oil currently has relative to domestic producers.

V)  Synfuels Tax Credit

The Act calls for tax credits for synthetic fuels from coal, worth an estimated $41 million over the next 10 years.  The feedstock must emit 20 percent less SO2 or nitrogen oxides when burned than standard coal in order to obtain the tax credit.  This proposal has a couple of problems.  First, by focusing on the burning of the synfuel, the language does not appear to stipulate that full conversion and consumption emissions must be lower than standard coal in order for the synfuels to get the credit.  Required processing prior to final combustion may also have releases (it certainly does have CO2 impacts), that should also be taken into account.  Second, there is no discussion of climate change impacts in evaluating eligibility for the tax credit.  Third, if effective, the provision will increase the market share of coal-based fuels in the transportation fleet.  While conceivably more environmentally beneficial than direct combustion of coal (this would depend on life cycle emissions which I've not evaluated), it is not at all clear that coal-based synfuels would be more environmentally desirable to using gasoline, ethanol, methanol, or natural gas in transport.

RECOMMENDATION:

Unless a clear and compelling case for the environmental benefits of the targeted fuels can be made, this provision should be eliminated.  

VI)  Tax Treatment of Nuclear Decommissioning Trusts

The Act will allow both regulated and unregulated utility owners to receive current tax deductions for contributions to qualified, external nuclear decommissioning trusts.  These contributions create a pool of money with which the very expensive cost of closing a nuclear plant can be met once the revenue-generating electricity sales have stopped.  Under standard tax law, such contributions would be deductible only over the decommissioning period at the very end of the plant life.

The Joint Committee on Taxation estimates that the modification in the tax law would be worth $1 billion over 10 years to nuclear utilities.  In my view, however, the up-front funding for closure, post-closure, and remediation costs is exactly the behavior that industries all over the country should be doing, be they landfill operators, nuclear power plants, or owners of oil and gas wells.  So long as funds accrued for these long-term costs are actually put beyond the reach of the firm and their creditors, I do not see immediate deductibility of these costs as a subsidy any more than deducting annual payments to a landlord would be.  The key question is really how "external" are the trusts for which these immediate tax benefits are being earned?  If they are not fully beyond the reach of corporate manipulation, creditors, or other claims on the company, not only would expanding deductions be unwarranted, but corrections to the loopholes to ensure financial security of these funds even under adverse market conditions would be vitally needed.  If they are truly external, providing immediate deductions for funding the trusts should be allowed.

RECOMMENDATION:

Congress should review in detail the exact parameters associated with qualified external nuclear decommissioning trusts.  Acceptable instruments should be modified to be sure they are managed and controlled by a disinterested, well-capitalized, and insured third party.  The legal status of these external trusts should be such that no creditor of the firm has access to the funds, unless such creditor has directly carried out the decommissioning services for which the fund was originally created.  This becomes ever more important as the ownership of nuclear reactors becomes concentrated in the hands of only a few companies.  Funds should not be tax deductible at all unless all access to the funds (including uses a collateral or as a balance sheet asset to boost corporate financial ratios) is lost.  In addition:

-Accrual of income in these funds now occurs at a reduced tax rate.  This allows nuclear utilities to put aside less money in order to meet their long-term obligations.  This reduced tax rate should be removed in order to put nuclear on equal footing with power sources that don't have the same high closure costs.

-Restrictions on the types of investments that a qualified fund can make, originally part of the parameters for qualified trusts when first enacted in 1984, were removed in subsequent legislation.  This potentially puts the principal of the funds at risk.  Congress should evaluate whether (a) some portfolio-based risk metrics should be required; and whether (b) ratings agencies such as Moody's or Standard and Poor should be enlisted to rate the risk and adequacy profile of each decommissioning fund on an annual basis.

-Recapture provisions, which ensure the firms do not benefit from purposefully overfunding decommissioning trusts, should remain in effect.


_______________________________
Doug Koplow
Earth Track, Inc.
2067 Massachusetts Avenue - 4th Floor
Cambridge, MA  02140
Tel:  617/661-4700
Fax: 617/354-0463
E-mail:  koplow@indecon.com

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